Although investor confidence in China has been hurt by the trade war with the U.S., a slowing economy, surging debt, and currency weakness, there are now more than 90 million stock investors in the country. At the end of 2018, China's stock market had a total stock market capitalization of 43.49 billion yuan.

Since widening the use of markets in the early 2010s, the Chinese government has not hesitated to insert itself into the markets when they do not cooperate with its policies. A notable example of the Chinese government's hold on its financial markets occurred during 2015-16 when their stock market crashed, producing an even greater distrust in market forces and leading to the government exerting even more control over its economy.

Key Takeaways

  • Although it has tried to adopt more financially liberal policies, the Chinese government has not hesitated to insert itself into the markets when they do not cooperate with its policies.
  • A notable example of the Chinese government's hold on its financial markets was its actions during a market crash that occurred during 2015-16.
  • At various times throughout the crisis, the government intervened to place trading rules and restrictions, such as banning sales by major stakeholders and restricting short-selling, in order to stem volatility.
  • It has been speculated that the government's actions during this time period actually exacerbated the economic crisis.

At various times throughout the crisis, the government intervened to place trading rules and restrictions, such as banning sales by major stakeholders and restricting short-selling, in order to stem volatility. However, it has been speculated that the government's actions actually exacerbated the economic crisis. Later examination suggested that the quick intervention by the Chinese government actually exacerbated the panic by creating more uncertainty.

Government Communication Campaign

China's stock market experienced an epic boom and bust in 2015. The initial surge from the middle of 2014 until June 2015 was fueled by a government communication campaign designed to encourage citizens to invest in the market. For months, the government touted the strength of the Chinese economy and made many promises to investors about the lengths it would go to in order to keep Chinese companies strong. The Shanghai market rallied from 2014 until the middle of 2015, nearly doubling in value. Then in June 2015, the bubble burst. More than 38 million new investment accounts had been opened in the two months leading up to this crash.

The more than 40% decline in the Shanghai Stock Exchange (SSE) Composite Index was only halted when the Chinese government purchased huge amounts of stock. When the markets declined again only a couple of months later in August 2015, the Chinese government took additional measures by lowering transaction costs and loosening margin requirements to allay fears of margin defaults.

Influence of Inexperienced Investors

The stock market bubble was largely driven by a massive inflow of money from small investors who bought up stocks on huge margins. For the most part, these inexperienced investors were the last to get into the surging market and the first to panic when it came crashing down. Unlike Western markets that are dominated by institutional investors, small traders account for the bulk of trades in the Chinese stock market. Since the inception of the Chinese stock markets in the 1990s, speculation rather than fundamentals has been the main driver of market surges. As a result, even the most experienced, savvy investors are left vulnerable.

Government-Enforced Lock-Up Period

During the steep market decline in the summer of 2015, the Chinese government instituted a six-month lock-up period on shares held by major shareholders, corporate executives, and directors who owned more than five percent of a company’s tradable stock. The rule was intended to prevent massive selling from occurring. The end of the first lockup period was in January 2016. and nearly four billion shares were set to become tradable again at this time. Government officials feared that this would trigger another steep decline so they extended the lock-up until additional rules could be established. Even in a mature stock market like the U.S., a mature stock market, the anticipation of the expiration of a share lock-up period has always created downward pressure on the market. In the case of an immature market, the effects are much more prominent.

Short-Selling Ban

Regulators also banned one-day short selling. Although this restriction stabilized stock prices for a short period of time, it may have been the cause of greater volatility. Short sellers are the only investors who buy during a stock market rout; without them, there is nothing to slow the decline. So, it's likely that the absence of short-sellers during this time period exacerbated the stock market plunge.

Installation of Circuit Breakers

Another profound demonstration of the Chinese government's intervention was the installation of circuit breakers that halted trading. After these circuit breakers were triggered three times, regulators took action, suspending their use because they did not have the intended effect. It has also been speculated that the use of circuit breakers may have worsened the crisis. In fact, regulators later admitted that the mechanisms may have actually increased market volatility.

Trial and Error Approach Created Uncertainty

Some market analysts have applauded the Chinese government’s willingness to intervene during this time period because it may have lessened volatility for a short time. However, their trial and error approach may also have created more uncertainty in the market, which is also a cause of volatility. The government's actions could be compared to a casino owner who keeps changing the rules to favor the house. In this specific instance, the government appeared to be manipulating the rules to favor a bull market. Unfortunately, it did not work and may have actually eroded the integrity of the system. Without question, one consequence of this episode was to cast doubt on the Chinese government’s ability to manage its financial affairs.